Is Amazon’s fairy retail story coming to an end?

When it comes to suspending disbelief about a lack of profits — the only
thing that ultimately matters when it comes to stock valuation —
Amazon.com has been in a class of its own.

By James B Stewart

Is a 20-year honeymoon coming to an end?

When it comes to suspending disbelief about a lack of profits — the only thing that ultimately matters when it comes to stock valuation — Amazon.com has been in a class of its own. Its price-to-earnings ratio, a common measure of stock valuation, has at various times topped 3,000 (the market average is about 18) — and that's when it actually has had a profit.

Investors never seemed to care. "Over the long history of the last eight years, this stock went from $60 to $400, which made all the doubters look stupid while all the believers got rich," said Bruce Greenwald, a professor and head of the value investing program at Columbia Business School. "The fact that Amazon did this in the face of deteriorating operating performance — slower growth in sales and the evaporation in profit margins — has made fools of the people who looked at the reality of its operations."

That may be changing.

On Thursday, Amazon reported that revenue grew a healthy 23 percent during the first quarter, topping analysts' forecasts and warming hearts of Amazon loyalists. Revenue gains have always been enough to drive Amazon's stock price higher, and it rose in after-hours trading. But then, on Friday, investors seemed to focus on the one thing they've always ignored: profits.

Although Amazon reported revenue of nearly $20 billion, it said its operating income fell 19 percent, to $146 million. Net income was a modest $108 million. Perhaps more unnerving was the company's forecast for next quarter: flat revenue and a loss that might be as big as $455 million.

Shares plunged, dropping nearly 10 percent, or more than $30, to just over $300 at Friday's close. They hit a record high of $408 earlier this year.

This is the second quarter in a row that Amazon's results have set off selling. Amazon shares plunged 11 percent on Jan. 31, after fourth-quarter revenue and profits were lower than analysts' forecasts. But this time, revenue beat forecasts, suggesting that it's the minimal profit that's worrying investors

Other technology stocks have also soared to what some investors have deemed absurd valuations. This week, the noted hedge fund manager David Einhorn warned, "We are witnessing our second tech bubble in 15 years." The market has been roiled in recent weeks, as it was on Friday, by sell-offs in some high-flying technology companies, including Netflix, Tesla and Twitter. But they are still relatively young companies that are trading on expectations that have yet to be tempered by reality, and none of them was as hard hit as Amazon.

Even after this week's plunge, Amazon's shares remain expensive by most measures. Its price-to-earnings ratio was still over 500.

Amazon's lofty valuation has long baffled many investors and analysts. But one thing they can agree on: Betting against Amazon has invariably turned out to be a mistake over the long term. (The stock has tripled over the past five years.)

Continue reading the main story A dozen Wall Street analysts lowered their ratings on Amazon on Friday, but until this week's earnings report, they were overwhelmingly positive about the company, with 35 of 44 analysts rating the stock a strong buy or buy. Until this week, downgrading Amazon — no matter what its valuation — hasn't been a path to popularity, as Eric J. Sheridan, an Internet analyst at UBS Securities, found out in February, when he reduced Amazon to neutral from buy. "Amazon is the third rail of investing," he told me this week. "I had hundreds of angry people calling me for days. How dare I say anything negative about Amazon?"

By contrast, investors punished Google last week after it reported strong revenue gains and billions of dollars of operating profit. "Investors won't cut Google any slack," Mr. Sheridan said. "I like Google. The valuation is very reasonable. The quote unquote shock, in their earnings, was that margins were a little weaker than expected. Google is spending on new initiatives. It's just a reminder that they're ambitious and innovative." That's exactly what investors have always said they loved about Amazon.

"Google shouldn't be viewed as a mature company," Mr. Sheridan said, but it is. Amazon, founded in 1994, is actually four years older than Google.

Stock prices are a reflection of investors' predictions of future profits, which is why there's always an element of gazing into a crystal ball. The future earnings of mature companies with long track records can be forecast with considerable accuracy, but for newcomers, especially in untested technologies, it's mostly sophisticated guesswork.

Amazon isn't a newcomer, but it has long had a powerful story driving expectations: the notion that it will become the global Walmart of Internet retailing. Walmart has been one of the most successful companies of all time and something of a holy grail for investors. Anyone lucky enough to have invested $1,000 in shares at the time of its 1970 initial public offering and have held them is now worth many millions.

Walmart's headiest growth is probably behind it, and Amazon is still expanding revenue by the 23 percent it reported this week. Still, the comparison to Walmart goes only so far. Walmart's operating profit margin is 5.6 percent. Amazon's is a minuscule 0.7 percent. Walmart has been consistently profitable since its earliest days, but for Amazon, bumper profits have always been just beyond the horizon.

So analysts and investors have tended to measure Amazon based on revenue rather than profits. On that basis, Amazon's price looks fairly reasonable: Its price to sales ratio is just over 2. (Google's is 5.7.)

But that seems to be changing. "With Amazon you've had a cult investor group that believed that all that matters is revenue growth," Mr. Sheridan said. "The problem is, in the last year and a half, the growth rate has started to slow quickly. It was 40 percent two years ago and now it's close to 20 percent." He said there were plenty of other Internet companies growing in the midteens to 20 percent, including Google, Priceline and eBay, and they're much cheaper. "Reality is starting to settle in," he said.

And Professor Greenwald noted that product sales — the core of Amazon's business — grew by only 18 percent in the quarter, and the projections for the next quarter also suggested slower revenue growth. "And profits were a disaster," he added.

Still, should the Walmart analogy cool, Amazon always seems to have another story. This week, it unveiled a deal to stream some HBO programs over the Internet, and it has been commissioning original programming. No matter that Amazon won't gain access to some of HBO's hottest properties, like "Game of Thrones." For some investors, Amazon is now the new Netflix. Or there's the cloud story, in which Amazon's cloud computing services makes it the new Salesforce.com. (On a price-to-sales basis, Amazon is cheaper than either Netflix or Salesforce.)

But perhaps Amazon is now spinning too many stories for investors to digest. This week, it also talked about getting into package delivery, a low-margin, high-cost business dominated by United Parcel Service and FedEx. And it even mentioned developing smartphones, an intensely competitive field that has already proved daunting for Google and Microsoft.

Still, if history is any guide, this week's drop in Amazon based on one quarter's results may just be another buying opportunity, and not a reversal of a 20-year trend. Mark Mahaney, an Internet analyst at RBC Capital markets, reiterated his outperform rating after the earnings were released, though he dropped his price target to $400. He still sees it as a compelling growth story. He noted that Amazon accounted for only 2 percent of global retail sales, "if that," adding, "So there's a belief that Amazon's long-term growth is likely to be more robust than Google's, because it has lower market penetration."

Mr. Mahaney said investors trusted Amazon's chief executive, Jeffrey Bezos, even though he's notoriously stingy about releasing information beyond that required by law, and have been impressed by his agility. Amazon "is a company that created devices when it was just a retailer and successfully went into cloud computing. People keep believing they can catch the latest trend. They've gotten a pass for that."

He described Amazon as a company that focuses on the long term. "To their credit, they've made big long-term bets that paid off and were willing to sacrifice short-term earnings," he said. "Getting the right valuation is tough, but I feel very strongly that five years from now," Amazon "will be a bigger part of global G.D.P. than it is now."